The turmoil in the financial markets arrived with great caution. And while it’s already a drastic move, the curveballs can’t be stopped. What’s more, although it doesn’t seem like the most likely option, it’s possible that so many curves will end the cause of the accident.
Beyond hikes that tighten financial conditions, central banks have entered uncharted waters with unprecedented coordinated balance sheet reductions. With the exception of the Bank of Japan, the other central banks have been draining large amounts of liquidity, in an orderly manner (albeit at varying rates), from the monetary and banking system that has been operating in an overstocked money market and at low interest rates. .
Central bankers themselves admit that the fiscal path is uncertain. The reduction of the balance will be like a car touch or randomimpact generated by touching another vehicle. The policy will be adapted to deal with market agents, with the risk of causing an accident. At the moment, the banks feel that the level of reserves is low, both in H and the ECB could lose control of effective interest rates (the commodity market in which banks lend money).
Once rates are out of control, rapid and decisive intervention by central banks is needed, as happened in 2019 in the US. However, in the process (from the rates of breathing government to the current central bank) many things can break, especially in a fragile environment such as today in which many commercial banks are already vulnerable and can move investors and depositors. money to the least sign of stress in the being. In 2019, things were different, rates were low and inflation was controlled, which allowed H to go all-in to return control rates. Today, the situation would be much more complicated. As we have seen these days, it is very little to make the bank run, it boils down some things and causes a credit crisis.
Where did we come from?
With the implementation of massive bond purchases (quantitative easing or QE) in the US, the Eurozone, The United Kingdom or Japan generated excess liquidity (money above the minimum reserve requirement and the bank’s own demand) modifying the operation of the bank. This process started after the financial crisis of 2008, but worsened during the economic crisis, when central banks injected large amounts of liquidity in a very short period of time.
Before the existence of QE (years before 2008), the change in the liquidity market changed the main interest, however, when excess reserves skyrocketed, reaching more than 4 trillion in the Eurozone, eg, liquidity changes stopped having an impact on the market. . If one day 5,000 million in cash disappeared, the interest that banks charge each other in the interbank does not want to move (there was a supply of liquidity). Now, by reducing the balance (quantitatively limiting or QT), the situation can be reversed.
Where are we going?
The numbers were originally printed. The Filch Agency published a report in which the balance sheet analyzes this coordinated reduction: “A huge change is taking place in the liquidity flow of central banks. The Federal Reserve, the ECB, the Bank of England (BoE) and the Bank of Japan (BoJ) They will be negative to the tune of $1 trillion in both 2023 and 2024. This large-scale global quantitative easing (QT) will be in stark contrast to what happened in 2022.”
Last year the global central bank balance increased by $500 billion, after it was increased to $5 trillion in 2020 and $3 trillion in 2020. This year the deduction will be $1 trillion, despite the fact that the BoJ will continue to increase its balance sheet.
“The amount of bonds on the QT market will increase somewhat, so the market will absorb this new supply for a period of time with still high government debt.” Meanwhile, banks have to adapt to a new environment in which liquidity will be lower and, above all, much more expensive. This generates significant risks as already seen. Rate hikes are beneficial to the profitability of the sector in the beginning, but at the same time they increase financial fragility and the risk that banks will “fight” for liabilities (to obtain deposits) as liquidity decreases.
Isabella Schnabela member of the Executive Board of the ECB, admitted that “the reduction of the balance sheet will reset this change, gradually moving the supply curve towards the steep side of the demand curve. In the current situation, there is still a large excess volume. the reserves mean that we are still far from that point (when the drop in liquidity rates can reach) “However, the uncertainty about the exact location of that goal is very high,” admits the German economist.
This means that the ECB and the other central banks have to park or pilot the reduction of balances “to touch”, that is, to gradually reduce the liquidity until a crisis is heard. There is a danger that this touch is too strong and an accident occurs with damage.
Intimidation in planning?
The German economist admits it today he does not know the level of reserves with which the banks operate without alarmwhich increases the risk of a crash, while reducing the two trillion dollars of liquidity, if ever, before anything breaks. What was seen with the American banks, Credit Suisse and the subsequent panic, 2024 probably reaches with this reduction of the balance sheet a very good prediction. It is a dangerous accident.
Schnabel explained in his QT speech that “one of the reasons is that years of large excess reserves have clouded our understanding of banks” underlying liquidity requirements. University aid levels are largely determined by the number of goods purchased. than through the liquid well of the banks,” he defended the German.
“If the demand for resources has grown more than is believed, then the upward pressure is on lending” may begin sooner than the opinions suggest of the historical relationship between excess resources and market traders”, Schnabel stated in his speech. Contact with other cars could be made faster than believed and broke without time.
Terror in the US in 2019
In the US they have something of an advantage, since H already came QT before the covid crisis. The moment was in 2019 when rates in the repo market (where banks and borrowers lend each other money for collateral, which is usually treasury bonds and bills) skyrocketed, generating panic and fear of a financial crisis. This happened in the US in the fall of 2019, when interest rates unexpectedly spiked, although the supply of reserves was still somewhat higher than the banks had indicated in their last surveys. low comfort”.
Fitch also refers to this complex point in its report: “The modern QT experience does not provide much assurance that it will pass without incident. The US money market experienced a large contraction in the first period of H QT with an effective rate of H ceiling in September 2019. “The exact point at which the amount of liquidity in the federal money market disappears overnight is unknown,” economists Filch admit.
Also in the most recent banking treatment report, the ECB also mentioned the risk that QT could frighten things: “The increase in interest rates and the quantitative tightening (QT) require banks to sharpen the focus on liquidity and the cost of risks. If the banks do not quickly adapt their risk management resources and direction the appropriate, more difficult funding environment can call into question the overly simplistic and clearly evasive asset and liability management strategies, as are the commercial practices that benefit from some banks, to be consulted by the extraordinary support of the state. There is a risk that this will catch some banks by surprise,” he warned .
Cumulative purchases of QE assets (net) by the Fed, the ECB, the BoE and the BoJ were $19.7 trillion between 2009 and 2022. “Although the balance of assets will remain high, a rapid reverse flow is now underway. Fitch Ratings expects the combined holdings. will drop to 1 trillion dollars both in 2023 and 2024 as H and ECB remove expiring holdings and BoE sells gilts, partially offset by BoJ purchases.
Although the turmoil in the markets was already evident and the economy could slow down sharply, the central banks did not even discuss the possible modification of their balance sheets. Ex Cambridge Associates Already two months ago, they warned of the possible impact of QT and its effects: “Central banks may have a higher threshold of market stress in the current sector, which could increase the volatility of safe assets and security assets.” equal risk
» Finally, We expect them to respond to severe episodes of stress in the financial markets“. The latter remains to be seen. Now the central banks have prioritized growth. It is also true that the sharp drop in the markets and the banks fell drastically, but it was short. For example, the stock markets seem to have recovered their tone in the next few days. If the turmoil turns into a full financial crisis would turn out, perhaps the response of the ECB, H or BoE would be different.